Internal rationality, imperfect market knowledge and asset prices

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DOI:	https://doi.org/10.1016/j.jet.2010.11.003
URL:	https://ub-madoc.bib.uni-mannheim.de/31901
Additional URL:	https://www.sciencedirect.com/science/article/pii/...
URN:	urn:nbn:de:bsz:180-madoc-319017
Document Type:	Article
Year of publication:	2011
The title of a journal, publication series:	Journal of Economic Theory : JET
Volume:	146
Issue number:	3
Page range:	1244-1252
Place of publication:	Amsterdam
Publishing house:	Elsevier
ISSN:	0022-0531
Publication language:	English
Institution:	School of Law and Economics > VWL, Internat. Wirtschaftsbeziehungen (Adam)
Subject:	330 Economics
Classification:	JEL: G12 , G14 , D83 , D84,
Keywords (English):	Learning, Internal rationality, Consumption based asset pricing
Abstract:	We present a decision theoretic framework in which agents are learning about market behavior and that provides microfoundations for models of adaptive learning. Agents are ‘internally rational’, i.e., maximize discounted expected utility under uncertainty given dynamically consistent subjective beliefs about the future, but agents may not be ‘externally rational’, i.e., may not know the true stochastic process for payoff relevant variables beyond their control. This includes future market outcomes and fundamentals. We apply this approach to a simple asset pricing model and show that the equilibrium stock price is then determined by investors’ expectations of the price and dividend in the next period, rather than by expectations of the discounted sum of dividends. As a result, learning about price behavior affects market outcomes, while learning about the discounted sum of dividends is irrelevant for equilibrium prices. Stock prices equal the discounted sum of dividends only after making very strong assumptions about agents’ market knowledge.